Learn All About Investment Banks and How They Differ From Local Banks

When the credit crisis unfolded, I heard a lot of investors asking the question “What is an investment bank and how does it differ from a regular commercial bank?” Unless you work in finance, the term “investment bank” likely did not present itself in your day-to-day life until the 2008-2009 global meltdown began.

What Is the Definition of an Investment Bank?

To put it simply, an investment bank is nothing like the corner institution you’re used to dealing with to get a business loan or deposit your paycheck.

Instead, an investment bank is a special type of financial institution that works primarily in high finance by helping companies access the capital markets (stock market and bond market, for instance) to raise money for expansion or other needs. If Coca-Cola Enterprises wanted to sell $10 billion worth of bonds to build new bottling plants in Asia, an investment bank would help it find buyers for the bonds and handle the paperwork, along with a team of lawyers and accountants.

Sometimes, investment banks come up with novel solutions to solve difficult problems. Several decades ago, holding company Berkshire Hathaway had only a single class of stock. Due to the fact that its controlling shareholder, billionaire Warren Buffett, had refused to split the stock, the shares had grown from $8 to $35,400; far out of the reach of the typical investor. Money managers were creating mutual fund-like structures to buy these shares and then issuing shares in themselves, taking a fee, to make the firm accessible to ordinary families.

Buffett didn’t like these middlemen making wild promises about the potential returns he could generate when he had nothing to do with it, so to take away their business, he worked with his investment bank to create a dual-class capital structure. In May of 1996, Berkshire Hathaway had an IPO for the Class B shares, which traded at 1/30th the value of the Class A shares (the old stock) but had only 1/200th the voting rights.

The Class A stock could be converted into the Class B stock at any time but you couldn’t convert the Class B stock into Class A stock. This allowed investors to effect what amounted to a do-it-yourself stock split while making cheaper shares wildly available.

Later, when Berkshire Hathaway bought the railroad Burlington Northern Santa Fe, the board of directors split the Class B stock so that it now represents 1/1,500th of the Class A stock. This resulted in the company being added to the S&P 500.

None of it would have been possible had investment banks not been working their magic. When well-regulated and prudently managed, they add a lot of value to civilization.